Published on December 10, 2013
1. 2. 3. 4. Fundamental concepts The Accounting Cycle Financial statements Comprehensive example
What is accounting? The language of business. A means to communicate financial information in a systematic manner. A way to convey information about a business to users. It refers to application of scientific and systematic knowledge of accounting.
According to American Institute of Certified Public Accountants (AICPA) Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character and interpreting the results thereof.
Who uses accounting information? Owners Managers Investors (including potential) Analysts on their behalf Creditors (including potential) Government (tax assessment) Regulators Customers
Accounting has two main divisions: Financial accounting Primarily prepared for users external to the company. Revenues, earnings, assets, etc. Management accounting Primarily for internal purposes Costing, budgeting, net present value, etc. This lecture will focus only on financial accounting.
There are several ways that cash gets into a company: Investment by owners Investment by creditors (loans) Payments from customers. Repayment of amounts loaned to other entities. Return on investments (interest and dividend) Proceeds from selling assets.
These can be organized into three categories: Operations Payments from customers Refunds from suppliers Financing Investment by owners Investment by creditors (loans) Investing Return on investments (interest and dividend) Proceeds from selling assets Repayment of amounts loaned to other entities
Financial accounting categorizes all transactions and events based on their substance. It is very important that the substance of a transaction be accurately reflected by financial accounting because the users of the information are using it with the assumption that these categorizations are being made accurately. If money invested by owners was reported as revenue, this would be counter to the fundamental definition of revenue (i.e. that it results from the operations of the company). The separation of income and capital is a fundamental concept of financial accounting.
Accounting Principles Accounting Conventions Accounting Concepts
Conventions are doctrines which state the customs and values. Conservatism Discloser Consistency Materiality
These are assumptions on which accounting is based Period Concept Dual Aspect Money Measurement Principle Realization concept Separate Entity Cost Concept Going Concern Concept Accounting Equivalence Accrual Concept Verifiable Objective Evidence Concept Capital Concept Matching Concept
Entity concept There are three basic structures that a company can have in Canada: 1. 2. 3. Sole proprietorship Partnership Corporation A sole proprietorship is not a legal entity separate from its owner A partnership is not a legal entity separate from its owners These are both sub-components of their owners/partners for legal purposes A corporation is a separate legal entity A business can be a separate entity for accounting even if it is not one from a legal perspective The entity concept for accounting does not simply follow the legal guidelines
Entity concept It is essential that we know for which entity we are accounting because it will determine if and how events are recorded. e.g. If Ms. Prop is the sole proprietor of a business called SP, there is one legal entity, Ms. Prop (SP is not a separate legal entity). If we wish to account for SP, there will be events to account for that are non-events from a legal perspective e.g. When Ms. Prop puts money into a separate account for the company. This is a non-event legally, but is an event to be accounted for from an accounting perspective.
Going concern It is assumed that an entity will complete its current plans, use its existing assets, and meet its obligations in the normal course of business. This is an underlying concept necessary for many of the fundamental recording and reporting decisions that are made in accounting.
Transaction or event occurs 1. Recorded in the Journal using a Journal Entry. 2. 5. event is translated into accounting language. Journal is posted to Ledger 3. 4. Could simply be the passage of time. the information from all the journal entries in the period is aggregated. Ledger accounts are totalled. Financial statements are prepared.
Transaction or event occurs Recorded in the Journal using a Journal Entry. Journal is posted to Ledger Ledger accounts are totalled. Financial statements are prepared. 1. 2. 3. 4. 5. It is important to note that the decision-making of accounting occurs at step 2 – Journal entry. Steps 3 – 5 are mechanical exercises. Therefore, the decisions made when making the journal entry (i.e. translating to accounting language) are very important as they determine what will ultimately be presented on the financial statements. cont’d on next slide…
Generally Accepted Accounting Principles (GAAP)
Fundamental Accounting Equation: Assets = Liabilities + Owners’ Equity This equation is always in balance In order for this equation to remain in balance, double-entry bookkeeping is employed. That is, the recording of every transaction or event must have at least two parts Either an equal impact (increase or decrease) to both sides of the equation or equal and opposite impact to one side. The recording of every transaction must keep this equation in balance
All journal entries have two “sides”: Debit and Credit For every journal entry, the total debits must equal the total credits This ensures that the fundamental accounting equation (A = L + OE) is always in balance. The basic journal entry: Debit Account name1 $amount Credit Account name2 $amount To record…
“Debit” and “Credit” are just accounting-speak for “increase” and “decrease” “Debit” means “increase” for some elements and “decrease” for other elements. Likewise for “credit”. For example, a company pays its $500 utility bill: In English: the company has incurred an expense (the amount of expense has increased) and the amount of cash in the company has decreased. An expense (Utilities) has increased An asset (Cash) has decreased In Journal entry: Debit Utility expense $500 Credit Cash $500 To record the payment of utility bill
How Convention exists based on what element is being increased or decreased. do we know whether to debit or credit? Each element “lives in” either debit or credit. If we want to increase something that “lives in” debit, we will debit it. The convention works such that the fundamental equation (A = L + OE) is always kept in balance.
The Basic Accounting Elements: Asset – Has future benefit to the entity Liability – Obligation to transfer assets in the future Owners’ Equity – Owners’ interest in the company Revenue – Increase in economic resources resulting from normal operations of the company Expense – Decrease in economic resources resulting from normal operations of the company
Going back to the Fundamental Accounting Equation: Assets = Liabilities + Owners’ Equity Debit Credit Credit
Assets Liabilities Owners’ equity
Assets Current assets Cash • Cash on hand Bank accounts • CIBC • BMO Accounts receivable • • Accounts receivable – customer 1 Accounts receivable – customer 2 Inventory Raw materials Work in process Finished goods • Product 1 • Product 2
Assets Current assets Long-term assets Buildings Ontario buildings Quebec buildings • • Montreal building Sherbrooke building Vehicles Cars Trucks • • Truck 1 Truck 2
Liabilities Current liabilities Accounts payable Accrued liabilities Long-term liabilities Bank loans • Loan from RBC • Loan from Scotiabank Notes payable Bonds payable
Owners’ equity Capital stock (direct investment) Retained earnings (indirect investment) Revenue Expenses (Dividends) • Although revenue and expenses are not subpieces of Retained earnings the way Current assets are a sub-piece of Total assets, for the purposes of understanding how they fit in to the equation, this representation is helpful.
The balance sheet is a permanent statement Its’ accounts accumulate information from the entity’s beginning. The amounts presented on the balance sheet are aggregated from the entity’s beginning to the balance sheet date. The income statement is a temporary statement Its’ accounts are temporary accounts They accumulate information for a period and then are reset to zero to begin tracking information for the next period. The amounts presented on the income statement are
The Closing Entry Whenever financial statements are to be prepared, the temporary (income statement) accounts must be “closed” to zero so that they can begin tracking data for the next period. The amounts in the accounts at closing are transferred to Retained Earnings (so named because it is the earnings (net income) of the company that is retained in the company and not distributed to the owners). We will see an example in the comprehensive example.
There are 4 statements in a standard set of financial statements 1. Balance Sheet 2. Income Statement 3. The “what do we have?” statement Shows what the entity owns and owes (the difference being the owners’ residual interest) The “what did we do?” statement Shows the activity the entity undertook in its normal course of operations. Statement of Retained Earnings Shows the changes in Retained earnings in the year 4. Often shown at the bottom of the Income Statement Statement of Cash Flows Shows the sources and uses of cash in the year Information is derived from the B/S and I/S and other
Company Name Income statement For year ended December 31, 2003 Company Name Balance Steet As at December 31, 2003 Revenue Expenses Salaries Utilities Rent Other 100,000 Net Income Closing Retained Earnings 43,000 96,000 4,000 Company Name Statement of Retained Earnings For year ended December 31, 2003 Opening Retained Earnings Net Income (Loss) Dividends 3,000 40,000 Total Assets 45,000 13,000 30,000 8,000 Assets Current assets Long-term assets Liabilities Current liabilities Long-term liabilities Owners' Equity Capital stock Retained Earnings - 3,500 4,000 500 7,000 15,000 20,000 35,000 1,000 7,000 8,000 Total Liabilities and OE 43,000
Cash Accounting Revenue is recorded when cash is received. Expense is recorded when cash is disbursed. Very straightforward. Facts determine the timing of entries. Less room for judgment. Accrual Accounting Revenue is recorded (recognized) when the revenue has been earned. When the product or service has been provided to the customer, regardless of when payment is received. Expenses are matched to the revenue that they helped to earn, regardless of when payment is made.
Journal Entries Usually one side (the Debit or the Credit) will be obvious from the transaction (e.g. when cash is received, cash (an asset) increases. The Debit has to be to cash). It is the determination of the other side of the entry that requires thought and judgment.
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